Kaufman Signals

October 2017 Performance Report

Industry Benchmark Performance

Early reporting shows lower gains then we would expect when all the data is updated. Equity long shows the best gains so far, a percent ahead of SPY in October. The SG Trend Index is close to our returns for October, while the BTOP 50 shows only half that return. It could be that the CTAs reporting early are the ones with the best performance. We still expect October to be a good month for both equity and futures traders. For updated returns, go to www.barclayhedge.com. We’ll update this table after more data is available.

Blogs and Recent Publications

(We’ve moved this section to the end of the report.)

October Performance in Brief

(If we only knew in advance which strategy would be most profitable!)

A great month but disappointing in the last week when those stocks that had returned so much during the month reversed. The biggest culprit was BIDU on Friday, Oct 27, when it took an 8% drop on a good report but a lower forecast of futures earnings (which they seem to do often, to set expectations lower).

The daily Trend stock portfolios are running neck-and-neck with the S&P, up an average of 15% for the year, with other trend portfolios up 8% to 9%. The small Timing portfolio is now up 24% for the year and the weekly stock portfolios up 9% and 15%. We’d all be happy if this happened every year.

Futures Trend has made a good recovery, up 4% to 6% for October, but the biggest winner is the Futures Divergence program, up 11% to 12% in October and 17% to 24% for the year. The gains this year have been concentrated in the equity index markets, no doubt the result of global optimism about a generally better economy. This is in sharp contrast to the norm, which is having interest rates as the biggest profit center. More about this in the “Up Close” section that follows.

Major Equity ETFs. Yet again the market has made new highs. Talk is becoming more positive about world growth, low inflation, and no end in sight. We get nervous when everyone is bullish, but we’ve had that same situation for years now and taking a defensive position would have hurt. Best to let the trend tell us when to be in or out.

Up Close: Waiting for Godot

In Samuel Beckett’s play, Waiting for Godot, the two main characters wait for someone who never shows up. It reminds me of how investors feel when they use a trend-following strategy. They wait and wait for a trend to produce profits; sometimes that wait can be very long. Unlike Godot, it will show up, we just never know when.

This month both the Trend and Divergence Futures programs returned exceptional profits, 5.61% in the $250K Trend portfolio, and 12% in the $250K Divergence portfolio. The latter program is now up 24% for 2017.

Could we have anticipated those gains? Where were they made? What did those trends look like? The problem is, we can’t anticipate which market will trend, and looking at a price chart doesn’t help. Consider our Daily Trend Program. The breakdown of returns by sector is shown in the chart below.

In most years, the interest rates are the foundation for profits. Until recently, yields have declined most of the years from 1980 to 2016. Equity index markets have traditionally been noisy. Using a long-term trend, those markets return small gains with a lot of volatility and are best suited for mean-reversion trading. But not since the bull market began in 2008. The sector breakdown of returns in 2017 are the opposite of the “normal” year.

The Reality of Returns

With hindsight we can always say that “there was no reason why the bull market would end.” But trading in real-time is always more difficult, and any flattening of price movement, or a modest reversal will cause a nervous trader to close out a long in the S&P. Let’s look at the reality of using a trend on SPY, starting from 2009, which is the beginning of the historic bull move. The chart below shows SPY from before the 2008 financial crisis. From 2009, the trend is clearly up.

When we trade a trend system, we give up some returns to get protection from a drawdown. A trend system must wait until after the trend has started up in order to enter, then gives up some of the profits when it waits to get out. In exchange, the strategy can hold its long position through some smaller ups and downs.

If we use simple moving average of 30-, 60-, and 120-days, we cover wide range of trends. In our example, the strategy goes long when the moving average turns up, and exits when it turns down. There are no costs. The next chart shows the returns of SPY and the 3 moving average systems, beginning January 2009, the start of the bull market.

Clearly, a buy-and-hold would have had the greatest return, but it also had the greatest risk. Had prices dropped the way they did in 2008, that risk would have been 50%, not limited by a rule that cut losses. In the last chart we see the returns and maximum drawdown of the four approaches. Buy-and-hold has the biggest return and the biggest drawdown, and both the returns and drawdowns get smaller as the trend gets faster.

“I Didn’t See Any Drawdowns”

You might wonder where did a drawdown in SPY get to be 35% after 2008? There were a number of times when large drawdowns occurred. During the first three months of 2009 there were drawdowns of 10%, 20%, and 28%. On October 3, 2011 there was a drawdown of 29%, and on February 11, 2016 there was a drawdown of 35%. We measure drawdown as the difference between the peak equity at the time, and the current equity, so if SPY reached a NAV of 250 before 2016, then posted a value of 215, that’s a 35% drawdown. If you have accumulated equity from the beginning, you would think of that as giving back $35 from a $150 profit, or only a 23% drawdown, but an investor starting at the wrong time would lose 35%.

Price movement is never smooth, and even the best “bull markets” have drawdowns. We can return good profits even in a market that doesn’t appear to be “trending” because of the price fluctuations, if we use a longer calculation period. Most important, we never know when we’re in that trend until afterwards, just like SPY now. And we won’t know that it stopped until afterwards. Using a system is the best way to capture those unexpected returns.

Portfolios Selected by Performance are High Beta

As a reminder, our automatic portfolio selection process uses past performance to select stocks and futures. Markets that are outperforming the averages tend to continue to outperform, but they also have higher volatility than the broad index. Outperformance means that profits on any day are higher, which also means that on a losing day, losses will usually be larger. It’s the basic principle of volatility and risk: you can’t achieve higher returns without higher risk.

Smaller portfolios that are less diverse are more likely to generate higher returns during “good” markets (the ones that work well for the strategy) and larger losses during “bad” markets. More diverse portfolios will have smaller gains and losses. To decide which is best for you, you must determine your risk tolerance and how much capital can be put at risk.

Trend Strength Index

One measure of market strength is our Trend Strength Index. Our Trend strategy is a composite of many trends, medium term to slow applied to about 275 stocks. When combined, these determine the position size of the current trade. If the faster trends are down but the slower one up, then the position size might be zero. The appearance is that trend positions scale in and out based on the strength of the trend. The Trend Strength Index appears at the bottom of the Trend Stocks All Signals report each day. We’ve tracked it from the beginning of 2014, and the chart below compares it with the SPY. TSI is the Trend Strength Index and SPY is the SPDR ETF.TSI values about zero indicate a positive trend. The range of the TSI is +1 to -1.

The Trend Strength Index reflects the internal strength (momentum) of all the stocks that we track, about 275. These stocks tend to have a stronger trend than the typical stock. It is also a mix of stocks from the S&P and Nasdaq, with a few smaller caps, but none trading fewer than an average of 1 million shares per day.

It’s been almost two years since the Trend Strength Index dipped under zero, twice topping near 60. For the past six months it’s averaged closer to 30. That indicates a positive but not a strong market. But we all know that. The S&P keeps moving higher, along with the other broad equity indexes. At some point we’ll see a significant break, but it wasn’t this month.

We offer this Index for those investors who select their own trades rather than following our sample portfolios. Daily Index values are available to subscribers.

Strongest and Most Undervalued Sectors

There are two ways to view sector rotation, trade the strongest expecting them to stay strong, or trade the weakest expecting the business cycle to rotate them to the top. We have both. The Trend Rotation trades the strongest and the Timing Rotation trades the weakest. The Trend program may hold positions for a long time, so it’s possible for two ETFs to be in both programs. For example, XOP (Oil and Gas) can be in a long-term uptrend, but a short-term oversold situation. The new Sector Rotation program also buys the strongest sectors and is reviewed with the Trend Equity Program.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.

When an ETF appears in both the Trend and Timing programs, it means that market is very strong but is in a short-term retracement.

A Standing Note on Short Sales

Note that the “All Signals” reports show short sales in stocks and ETFs, even though short positions are not executed in the portfolios. Our review of using inverse ETFs to hedge stocks during a decline showed that downturns in the stock market are most often short-lived and it is difficult to capture those moves with trend systems. This confirms our approach to the Timing systems, which hedges up to 50% of the long stock risk using multiple trends. In the long run, returns from the hedges are net losses; however, during 2008 the gains were welcomed and reduced losses. In any correction, we prefer paying for risk insurance, even without the expectation of a net gain.

Portfolio Methodology in Brief

All of the programs, stocks, ETFs, and futures, use the same basic portfolio technology. They all exploit the persistence of performance, that is, they seek those markets with good long-term and short-term returns, rank them, then choose the best, subject to liquidity, an existing current signal, with limitations on how many can be chosen from each sector. If there are not enough stocks or futures markets that satisfy all the conditions, then the portfolio holds fewer assets. In general, these portfolios are high beta, showing higher returns and higher risk, but have had a history of consistently out-performing the broad market index in all traditional measures.

PERFORMANCE BY GROUP

NOTE that the charts show below represent performance “tracking,” that is, the oldest results are simulated but the newer returns are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted.

Groups DE1 and WE1: Daily and Weekly Trend Program for Stocks and ETFs, including Sector Rotation, Income Focus, and Dow Arbitrage

The Trend program seeks long-term directional changes in markets and the portfolios choose stocks and ETFs that have realized profitable performance over many years combined with good short-term returns.

Gains of more than 3% and 4% in the 10- and 30-stock portfolios now total 16% and 15% for the year, in addition to making new equity highs. While this is in-line with the S&P, a strategy also protects the downside, which is not the case for an outright position in SPY. ETFs are now making a good upwards move, an acceleration of the recovery following the 2014 drop.

Slightly lower returns in the weekly stock and ETF programs, but still quite good. The larger 30-stock program has been outperforming the smaller portfolio, which is unusual. The 10-stock portfolio is now up over 9% for the year, while the larger portfolio is higher by 15%.

The ETF portfolios also gained 2% and 1.4% for October, a respectable return, bringing their 2017 totals to between 6% and 7%.

Income Focus and Sector Rotation

Both daily and weekly Income Focus programs lost about ½% in October, leaving the yearly returns at 2.24% and 3.21%, respectively. A bit disappointing, but with very low volatility, as advertised. We’d like to see a gain of 1% to 2% by the end of the year.

A return of 1.4% in October is good, but Sector Rotation has been disappointing in a year when stock returns are between 10% and 20%. There’s been too many shifts from one sector to the other as investors try to figure out which are healthiest compared to the others. The program has been in an uptrend for the past two years, so we remain committed.

DOW Arbitrage

This program remains the top performer for 2017, gaining another 3% in October, up 24.25% for the year. We had a 1-week hedge, based on high volatility, reducing the size of our long positions and selling short the weakest stocks in the Dow. Even covering those shorts one week later didn’t hurt our returns and offered important protection if the market had decided to turn down.

Group DE2: Divergence Program for Stocks and ETFs

The Divergence program looks for patterns where price and momentum diverge, then takes a position in anticipation of the pattern resolving itself in a predictable direction, often the way prices had moved before the period of uncertainty.

The Equity Divergence program made small advances in October, in both the stock and ETF portfolios. While lagging behind the major equity index markets, it offers excellent diversification and lower volatility.

Group DE3: Timing Program for Stocks and ETF Rotation

The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. Its primary advantage is that it doesn’t depend on market direction for profits, although these portfolios are long-only because they are most often used in retirement accounts. When the broad market index turns down this program hedges part of the portfolio risk. The ETF Rotation program buys undervalued sectors, expecting them to outperform the other sectors over the short-term.

The Timing Program buys undervalued stocks so that it will buy the weakest even in a declining market until that stock shows that it is not expected to rally. Risk is protected with an absolute stop of 15% and also by hedging the broad index.

The small 15-stock Equity Timing portfolio was up 6.6% in October, now totaling over 24% for 2017. The larger portfolio gained 2.5%, which seems disappointing in comparison. But a larger set of stocks will introduce some with lower returns. The sector ETF program gained less than 1% and continues its slightly rising pattern.

Futures Programs

Groups DF1 and WF1: Daily and Weekly Trend Programs for Futures

Futures allow both high leverage and true diversification. The larger portfolios, such as $1million, are diversified into both commodities and world index and interest rate markets, in addition to foreign exchange. Its performance is not expected to track the U.S. stock market and is a hedge in every sense because it is uncorrelated. As the portfolio becomes more diversified its returns are more stable.

The leverage available in futures markets allows us to manage the risk in the portfolio, something not possible to the same degree with stocks. This portfolio targets 14% volatility. Investors interested in lower leverage can simply scale all positions equally in proportion to their volatility preference. Note that these portfolios do not trade Asian futures, which we believe are more difficult for U.S. investors to execute.

Using the same strategy and portfolio logic, the Weekly Trend Program for Futures has the added smoothing resulting from looking only at Friday prices. While it will show a larger loss when the trend actually turns, most price moves are varying degrees of noise which this method can overlook.

Please read the report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”

A welcome reprieve from months of torture. Both daily and weekly Futures Trend portfolios gained nicely in October. The daily program up from 3.29% to 5.61% and the weekly program up 2.94% to 4.60%. The 250K daily program is now up 14% for 2017 and the 1M program up 9.36%. The mid-size 500K program is just up 2%. Each of these portfolios trades an increasingly larger set of futures markets, so the variation is understandable. Although difficult to see on the weekly chart, October’s returns go a long way towards recovering from a nasty drawdown earlier in the year.

Group DF2: Daily Divergence Portfolio for Futures

The Divergence Futures program is the pick of the litter this year, up 10% to 12% in October, and up 17% to 24% for 2017. It shows that wide equity swings are normal based on the few markets held at any one time.

Blogs and Recent Publications

Mr. Kaufman will be a speaker at the Money Show Expo in New York at the end of February. He will also give a 3-day seminar in Chicago, March 5-7, on developing a successful trading strategy, sponsored by the Chicago Institute of Investing. It will be in English and Chinese. For more information contact Katie.Tian@chicagoii.com.

Mr. Kaufman was a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) held in Milan, Italy, in October 12-16, 2017. A video of the presentation has been posted on the IFTA website.

“Portfolio Risk in Uncertain Times” was just posted on Seeking Alpha. It shows a better way to structure your portfolio. Prior to this, you will find “Living Off Profits,” which shows how much you can safely withdraw from your account without seeing spiral down out of control. Before that Seeking Alpha published “What Are the Odds?” a look at how to assess the risk of loss for any investment.

Technical Analysis of Stocks & Commodities will publish a two-part article on profit-taking and resets. The first part looks at trend following systems and the second at short-term trading. Before that, they published “Optimization – Doing It Right,” in the September issue.

Modern Trader published “Dogging the Dow in the current edition, and a new article “Trading Opening Gaps” in stocks, scheduled for January, 2018.

The IFTA Journal published an interview with Mr Kaufman in the most recent quarterly issue.

The broker FXCM will post a live interview with Mr Kaufman, taped on October 30.

ProActive Investor Magazine published Keeping Risk Under Control on June 22. Check their website. It will be publishing other articles later this year.

Andrew Swanscott at BetterSystemTrader.com (a good source for trading systems) has put up an edited version of an older presentation of Mr. Kaufman’s. It’s all about price noise and the Efficiency Ratio.